FRANCHISING LAW CHANGE IN NEW YORK

The state of New York has launched what may become an effort to tax franchisors with franchisees operating in the Empire State, no matter where the franchisors themselves operate.

The state’s opening gambit is a provision in its annual budget legislation requiring that out-of-state franchisors inform the New York Department of Taxation and Finance of the identities and addresses of franchisees located in New York, along with detailed data on:

• Gross sales for each New York franchise location as reported to the franchisor, and as audited by the franchisor;

• Gross New York sales taxes collected by each franchisee;

• Royalties paid to franchisors by their New York franchisees, along with details as to how franchisors compute royalties;

• Gross sales to New York franchisees by franchisors or their affiliates, or by any suppliers designated by franchisors.

Franchisors were required to submit information returns before Sept. 20 covering New York operations through Aug. 31, and they should obtain expert legal advice before complying.

For one thing, the state’s gambit probably isn’t innocent. New York says it just wants to know whether franchisees comply with tax laws. But the legislation raises complex issues under the Constitution’s commerce clause and the due-process clause of the 14^th Amendment, and no one knows where the courts might take these issues.

WHAT EVERY LAWYER SHOULD KNOW ABOUT FRANCHISE LAW – Part 3

In recent blogs, I’ve talked about three critical facts to know about franchise law.  Here are the final two of which to be aware.

4. The state exercises little or no oversight over licensing, distributorship, or dealership arrangements; however, it exercises a great deal of oversight over franchisors and franchisees. In my last two blogs, I’ve discussed three critical facts to know about franchise law.  Here are the final two of which to be aware. It is precisely because the state does so that attorneys must make sure their expansion-minded client companies do not step over the line into franchising inadvertently. If that happens, companies must take on burdens not imposed on firms entering into licensing, distributorship, or dealership arrangements. Among other things, franchisors must:

• File franchise disclosure documents with the Department of Corporations outlining the franchising opportunity in detail along with the franchisor’s own background and business experience, among other matters, before entering into any discussions with potential franchisees, and

• Obtain Department of Corporations approval for any “material modifications” they want to make to existing franchise agreements before presenting them to franchisees, including any new or modified provisions regarding royalties, fees, Internet commerce, and territory rights.

5. The Department of Corporations closely polices franchisor-franchisee arrangements, and it has authority to assess penalties of $2500 per violation on companies operating in violation of the many details of franchise law. Even here, however, there is more to the story. Suppose that a company enters into arrangements with half a dozen other companies involving trademarked products or services, unaware that the details of the arrangements establish franchisor-franchisee relationships. At some point, the first company discovers its error but, having profited by the arrangements, decides that it really wants to be a franchisor after all.

Before it can square things with the Department of Corporations, it must give its half dozen inadvertent franchisees the right to rescind the original arrangement and get their money back—meaning not only their original investment but also any losses they may have incurred less any profits. This can prove painful, even ruinous to the inadvertent franchisor.

Clearly, the better idea is to avoid the pain. Franchising is a complex business, and although it can prove a highly effective expansion strategy, entrepreneurs must know beforehand whether the arrangements they enter into with other firms do or do not constitute franchisor-franchisee agreements—and if so, of course, whether this is what the parties want.

WHAT EVERY LAWYER SHOULD KNOW ABOUT FRANCHISE LAW – Part 2

In my last blog I addressed how the law determines if a business qualifies as a franchise.  Here are other pitfalls that face the unwary.

2. One key to determining the character of the relationship is the independence of the two enterprises. In the eyes of the law, the contractual arrangements between franchisors and franchisees make the latter dependent upon the former. Franchisees sell or distribute the trademarked products or services of franchisors, usually in exclusive territories—that is, territories in which the franchisor will not permit other franchisees to operate. They also rely on franchisors for advice, training, and advertising and marketing assistance. In some cases, franchisors may serve as exclusive suppliers of the products or services sold by its franchisees.

3. Licensing and distributorship or dealership arrangements, on the other hand, are relationships between independent companies, each operating under its own trade name, and each largely uninvolved in the operation of the other. Thus, under typical licensing arrangements, one company permits another to sell its products or services in exchange for a percentage of the proceeds, with no other involvement in the affairs of the other company. Under typical dealership or distributorship arrangements, a company operating under its own name undertakes only to buy the products or services of another at wholesale prices for purposes of resale, once again with minimal involvement of either company in the affairs of the other.

Next week we’ll explore additional legal issues facing franchisors and franchisees.

WHAT EVERY LAWYER SHOULD KNOW ABOUT FRANCHISE LAW – Part 1

Too often, expansion-minded business owners opt for a strategy offering trademarked products or services through licensing arrangements or distribution or dealership systems only to discover, well into the game, that what they have really done is turn themselves into franchisors—“accidental franchisors,” maybe, but franchisors nonetheless.

This is good news for the entrepreneur who runs a sophisticated business operation capable of meeting the many punctilios of California franchise law. It is bad news for the entrepreneur who doesn’t. In fact, it can spell disaster for the unwitting entrepreneur who steps over the fine line that separates franchising from other commercial arrangements involving trademarked goods or services.

1. California law defines a franchisor as one who offers, sells, or distributes trademarked goods or services through one or more “substantially associated” business enterprises following a marketing plan “prescribed in substantial part” by the franchisor in exchange for fees collected directly or indirectly from the associated business enterprises. The second of these phrases is self-explanatory. But what does “substantially associated” mean? The test is simple. If a business enterprise uses the trademark of another company to identify its business, it is “substantially associated” with it under the eyes of the law.

But there is more to the story.  A business also may be a franchisor if it allows another business to use its trademark and it also:

• Provides the other business with advice and training as to the sale of its products or services,

• Exercises significant control over the conduct of the other business,

• Grants the other business exclusive rights to sell its products or services in specific territories, or

• Requires that the other business purchase or sell specific quantities of its products or services.

Unfortunately, expansion-minded entrepreneurs may seek to institute one or another of these practices when negotiating licensing or distributorship or dealership arrangements with other companies. This makes it crucial for attorneys involved in setting up any such arrangements to determine whether the practices push the relationship between the companies into the realm of the franchisor and franchisee.

See next week’s blog when I discuss additional potential pitfalls.

FRANCHISE LEGAL DUE DILIGENCE CHECKLIST – Part 2

In addition to the items discussed last week, here are additional items that should be reviewed as part of the due diligence checklist:

• All royalty relief agreements, forbearance agreements, settlement agreements, general releases, cancellation agreements, termination agreements and purchase agreements (for the reacquisition of franchised units) with franchisees and area developers, whether signed, unaccepted or otherwise unsigned since the date the franchisor first became registered to sell franchises;

• List of all persons who acted as franchise salespersons or brokers to offer or sell franchises and all salesman disclosure forms filed with each state’s agency that regulates franchise offers and sales for the last four years;

• All policy announcements, memos to franchisees, newsletters, reports, etc., issued to franchisees and area developers since the date the franchisor first became registered to sell franchises;

• All notices of breach, default and termination issued to franchisees and area developers since the date the franchisor first became registered to sell franchises;

• All claim and demand letters received from franchisees or area developers since the date the franchisor first became registered to sell franchises;

• All print advertising published to advertise the franchises;

• All flyers and brochures used to advertise the availability or offer or sale of franchises;

• All website advertising availability or offer or sale of franchises;

• List of all pending sales of franchises and area development rights

• List of all pending transfers of franchises and area development rights;

• List of all pending franchisee outlet openings and closures;

• List of all franchises and area developers not current in the payment of their obligations to the franchisor with the details of such defaults;

• List of all area developers not current under their development obligations with the details of such defaults;

• List of all franchisees and area developers whose franchises and area development rights were transferred, canceled, terminated, not renewed, reacquired or who otherwise left the system since the date the franchisor first became registered to sell franchises;

• List of all litigation and arbitration matters between the franchisor and franchisees and area developers filed, settled, adjudicated or otherwise resolved since the date the franchisor first became registered to sell franchises;

• Copy of all acknowledgments of receipt from each franchisee who received a UFOC since the date the franchisor first became registered to sell franchises;

• List of memberships in franchise organizations such as International Franchise Association.

In deals involving large numbers of franchisees, it becomes impractical to obtain and inspect every document on this checklist, of course. In such cases, the lawyer should sample a number judged reasonable by the client and shape the language of any representations and warranties accordingly.

LEGAL DUE DILIGENCE FRANCHISE CHECKLIST

The business lawyer doing due diligence in the purchase of a franchise company must track down a great many documents to gain an accurate picture of the relationships between the franchisor and its franchisees.

Then the real work begins, since it is also necessary to inspect the documents in detail and draw up representations and warranties holding the seller of the franchise company responsible for any agreements or information contrary to or inconsistent with the documents inspected or information provided during due diligence.

Here are just some of the documents and information the lawyer should obtain and review:

• Each UFOC used by the franchisor in all states in which the franchisor has done business for the last four years, including all state-specific addenda;
• Each signed franchise agreement and area development agreement, if applicable, and all ancillary agreements and attachments used in the last four years;
• All signed amendments to franchise agreements and area development agreements used in the last four years;
• Drafts, proposals, unaccepted or otherwise unsigned amendments to franchise agreements and area development agreements used in the last four years;
• All correspondence to or from any state agency regulating franchise offers and sales in any state in which the franchisor has done business for the last four years, including registration orders and exemption filings;
• All orders and correspondence issued by or received from all such state agencies for the last four years and a list of all pending franchise registration and exemption filings;
• All consent orders, assurances of discontinuance, notices of violation, offers of settlement, settlement orders or other orders or rulings in effect or, to the knowledge of the seller, threatened that would prohibit or impede the buyer’s ability to offer or sell franchises or enter into franchise agreements.
• All communications to or from the Federal Trade Commission, if any, or any agency of any state in which the franchisor has done business, or has attempted to do business, for the past four years, whether in the nature of an inquiry or otherwise – for example, communications to or from agencies that regulate offers or sales of business opportunities.

Next week, we’ll talk about additional documents and items that are important.

MONEY IN THE BANK: HOW TO VALUE A LARGE FRANCHISEE BUSINESS – Chapter 3

The good news in all of this is that a profitable large franchisee with, say, 50 outlets up and running, and with rights to open up another 50 in a promising market, may well command a substantial premium in a sale to a private equity group. This is true not only because it costs less to buy 50 businesses from one seller than from 50, but also because a successful large franchisee stands in good position to command financing on good terms, attract professional management, and achieve efficiencies of scale in overhead costs – for example, by building its own warehousing. Similarly, the large franchisee may be less subject to downturns in local market conditions than unit franchisees who depend on particular neighborhoods.

Size, in short, can do good things for the large franchisee’s business in the eyes of a buyer, and although factors unique to any such business will determine how much it will bring in a sale, what is certain is that franchise companies as a whole command higher multiples than non-franchise companies; data from recent transactions show that fast-food franchisors bring multiples of six to eight times EBITDA, or earnings before interest, taxes, depreciation, and amortization, whereas non-franchise fast-food companies bring only four to five times EBIDTA.

It is equally clear that, given the increasing importance of large franchisees in the restaurant industry, they are likely to continue attracting attention from private equity groups, particularly now that a number of franchisors – for example, the Quizno’s and Subway sandwich shop chains, SONIC Corp. of the SONIC drive-in hamburger chain, and IHOP Corp. itself – expect much of their growth to come from area developers.

Private equity groups like this dynamic, and that pushes values up – good news for large franchisees, because it means that, having devoted themselves to building successful businesses, they now stand in good position to realize a profitable exit.

MONEY IN THE BANK: HOW TO VALUE A LARGE FRANCHISEE BUSINESS – Chapter 2

In valuing the operations of a large franchisee, the game begins with a disciplined effort to understand who owns what in that web of assets and rights and to determine how much each factor contributes to the whole or detracts from it.

Of primary importance, of course, is the fact that the large franchisee holds the right to open up new outlets in specific areas. This is often the chief allure in the eyes of a buyer, but the analysis of value must take other factors into account as well, among them:

• The profitability of the units the franchisee has up and running now;

• The efficiencies of scale the franchisee enjoys;

• The equipment held by the franchisee, whether owned or controlled through leases;

• Real estate owned or leased by the franchisee, including any restaurant pads at large shopping malls, which often command a particular premium because of their location;

• The franchisee’s management team;

• The legal relationship between the franchisee and the franchisor;

• The terms under which the franchisor offers marketing, training, financing, or other support to the franchisee;

• The number of additional outlets the franchisee has committed to opening up in its exclusive territory in a given period of time;

• The demographic and economic conditions in the franchisee’s exclusive territory, and

• Last but not least, the franchisee’s access to financing and other resources necessary to taking advantage of expansion.

MONEY IN THE BANK: HOW TO VALUE A LARGE FRANCHISEE BUSINESS

Private equity groups have eagerly stalked restaurant franchisors in recent years, snapping up such companies as Dunkin’ Brands, owner of the Dunkin’ Donuts and Baskin Robbins chains, along with Hamburger Hamlet, Applebee’s, Chevy’s, and Worldwide Restaurant Concepts, owners of the Sizzler chain.

These days, however, in their eagerness to put their money to work in the restaurant industry, private equity groups are stalking large franchisees, too, and even other private equity groups with franchised restaurant holdings. Last year, private equity groups bought out large franchisees of IHOP Corp. and the Papa John’s Pizza and Church’s Chicken chains, and in 2005 Sun Capital Partners, Inc., bought Garden Fresh Holdings, Inc., from the private investment firm Centre Partners Management LLC. For that matter, even large franchisees have gone on buying sprees; Heartland Food Corp., for example, which operates about 250 Burger King outlets in half a dozen states, has been out snapping up smaller operators in recent years.

Clearly, successful large franchisees are desirable commodities these days, leading many of the people who run such businesses to wonder what their own operations might fetch in such a hot market. But the value of a successful large franchisee company lies hidden in a web of assets and ownership rights, some attributable to the franchisee, some to the franchisor, and some to other parties altogether, and the key to deriving it is to tease apart that structure of ownership, analyzing each layer as well as the whole. That is not an easy task, since relationships among the parties in a franchise enterprise are so complex as to make the whole sometimes worth more than the sum of the parts, and sometimes worth less.

Master Franchisees Beware

Last but not least, master franchisees should review the ways in which they encourage unit franchisees to expand their businesses. The contracts between these parties typically allow the latter to drum up business on their own – one sign of an independent operation – but in many cases master franchisees do all the prospecting for new customers, in effect telling unit franchisees that they have clients wanting service and that the limits on unit franchisee income depend only on how many territories the unit franchisees can afford to buy up and service.

Regulators say this practice amounts to nothing more than an employer providing leads to its employees – as, for instance, an insurance agency might supply leads to its agents. In most cases, regulators say, unit franchisees actually provide services only to clients of the master franchisee, no matter what the agreement between the parties says.
 
A big challenge in reviewing these contractual and practical arrangements is that not all agencies in a given state test for franchisor-franchisee relationships in the same way, irrespective of the provisions of state law. Indeed, many agencies look for different signs of the relationship and rule accordingly, the result being that one agency may deem a particular relationship to be that of a franchisor and franchisee where another sees an employer-employee relationship. To make matters worse, because case law holds that such rulings by one state agency are not binding on others, this can leave companies in a kind of legal limbo.
 
Even more ominously, in several states including California, franchisors of all kinds now face the threat of litigation from the plaintiff’s bar under new provisions of state law allowing plaintiff’s attorneys to bring suit against private businesses for violations of employment law – in the past the job of state regulatory agencies only. The incentive in these new provisions of state law is that the penalties for such violations may flow not to the state, as in the past, but to the attorneys themselves.
 
Clearly, franchise operations in the industries under scrutiny face threats on several fronts, and they must step carefully if they are to thrive. This will not be easy, given the traditional informality of business arrangements among many operators in the industries now under scrutiny, among them their tendency to hire unskilled, often illegal immigrant laborers who do not speak English and know nothing of American franchise and labor law. But the alternative is worse.